2022’s great inflation debate divides economists and market observers into two distinct camps: Those who believe inflation is still at least some semblance of transitory (even if they won’t use that adjective anymore), and those who believe inflation is embedded and will likely be with us for the foreseeable future.
Believe it or not, those two camps have one thing in common: Neither thinks inflation is now stochastic, and thereby completely beyond economists’ and policymakers’ capacity to predict, let alone control.
In a somewhat petulant debate carried out over Twitter earlier this week, Larry Summers and Paul Krugman each cited data and alluded to economic modeling in arguing both sides of the inflation debate. Summers, of course, believes inflation is likely to stick around barring a deep recession. What Summers hasn’t argued (or at least not that I’m aware of) is that inflation is going to stick around irrespective of any recession or at least could stick around regardless of the economy’s trajectory.
This failure of imagination on the part of economists is rooted in arrogance and hubris on both sides of the discussion. The transitory camp and the Summers camp both assume inflation is a thing that policymakers are capable of influencing. I’ve repeatedly asked readers to consider Zoltan Pozsar’s contention that such thinking may be at least partially erroneous.
Yes, supply and demand will always matter, but geostrategic jostling and the associated weaponization of energy, food and finance itself, could make controlling inflation by way of demand destruction almost impossible, at least if “control” is supposed to mean managing inflation around some target low enough to guard against societal upheaval or, if that’s too strong, call it public discontent.
I’ve written voluminously on this. Most readers have probably had their fill, but for those who haven’t, I encourage you to peruse “The Charge Fed Critics Miss Is The Most Terrifying Of All” and “What If ‘Normal’ Isn’t What We Think It Is?” The point here is simply to draw your attention to the figure (below) from the October vintage of BofA’s Global Fund Manager survey.
Almost 80% of respondents to BofA’s poll expect lower inflation in the next 12 months. The bank’s Michael Hartnett noted that the proportion has been “stable… suggesting the world economy is currently at peak inflation.”
There’s just one problem: Actual global inflation was almost 10% last month, and very much unlike previous episodes when investors overwhelmingly saw lower inflation going forward, realized inflation hasn’t just refused to roll over, it’s accelerated relentlessly.
Have a look at the time frame covered by the survey (i.e., the x-axis on the chart). It’s just The Great Moderation. That’s potentially problematic. Because part and parcel of the stochastic inflation argument is the idea that The Great Moderation was an anomaly, not any new normal.
As I put it last month, there’s a sense in which central banks’ fraught efforts to rein in inflation are a reflection of the futility inherent in the developed world’s broader struggle to reclaim something that was never real in the first place. Recency bias and, to a lesser extent, misplaced optimism about humanity’s capacity to cooperate in pursuit of something greater than wealth and territory, led too many of us to the naive conclusion that the latter decades of Pax Americana and, in the economic context, The Great Moderation, were somehow the norm, rather than the exception.
If we look up six months (or really, even four months) from now, and charts like the one above still show a yawning disparity between actual inflation and our expectations for price growth, then it might be time to consider the uncomfortable notion that the whole “genie out of the bottle” metaphor can be taken a bit more literally than we thought.
Magic genies aren’t real, but in folklore, coaxing them back into the lantern isn’t a matter of policy choices based on any sort of modeling or reason. To the extent it’s possible, it usually entails — I don’t know — incantations of some sort.
As painful as tighter financial conditions predicated on higher terminal rate pricing and associated dollar strength most assuredly are, it’s nothing compared to what would unfold in the event the Fed lost all control of the long-end, and an explosive, disorderly bear steepener was unleashed on a world still hopelessly long duration.
Your discussion says highlights where economists are extremely weak. What happens when the structure of the economy changes? It is the reason I quit economics graduate study. I thought the discipline was severly lacking in this kind of wisdom. There is a discontinuity (I am teaching my daughter limits right now in calculus so the metaphor is clear). The graphs have two answers depending on the outcome of the structural question or many more. If the structural change is not as large as now, and Russia and Ukraine war is untangled gives you one answer. Covid recedes over the next 2-3 years (Osterholm projection at the beginning of the pandemic for the US). Then, tightening monetary policy works with a lag to bring down inflation over the next few years starting in 2023. You can construct plenty of other scenarios given many of geopolitical events events though. And the scenarios will have more to do with how events play out, rather than whether Powell & Co raise rates by 50 or 150 bps. The longer your time horizon the greater the chance that these events converge or offset each other- in the nature of factoring an equation and identifying removable discontinuities in a calculus problem dealing with limits. Ok enough math applications to human events. The over quantification of the economics profession years ago, is what drove me away in the first place. Thanks for listening…
sto·chas·tic
/st??kastik/
adjectiveTECHNICAL
randomly determined; having a random probability distribution or pattern that may be analyzed statistically but may not be predicted precisely.
Perfect word choice Mr H.
I have the Great Disorderly Bear Steepener targeted for June 2023. It almost feels inevitable at this point.
Hold on to your doorstop.
Yes, supply and demand will always matter, but geostrategic jostling and the associated weaponization of energy, food and finance itself, could make controlling inflation by way of demand destruction almost impossible
So inflation is still the result of human actions and thus subject to cause and effect? It’s hard to argue it’s then stochastic. It’d be more proper to say that we don’t have control over Xi and Putin (by the way, that’s 2 men with revanchist dreams rather than “humanity being unable to rise beyond imperial hubris”) and that’s a problem b/c we’ve allowed ourselves to become too intertwined with these morons.
The solutions remain relatively simple : we could go to rationing & price control if needed but how much would we achieve if, say, ethanol subsidies were finally cancelled? I mean, invent whatever subsidies is needed to keep farmers placated, just let the produce be used for food rather than a fake energy supply.
Ditto – could the US government not encourage fracking again by guaranteeing returns to frackers regardless of oil prices? I seem to recall this was done for wind power… And Europe could allow some fracking to take place at all – much as I don’t like the idea of the collateral ecological damage we’d have to endure because of it.
And, obviously, we could all raise taxes on the top 20% to help cushion the transition to the big CAPEX efforts that is now needed to reshore energy and manufacturing.
So – is inflation a genie out of a bottle? Maybe. OTOH, it might be our politicians are just too afraid/too incompetent/too distracted to tackle it heads on.